Beware Commodity Exchange-Traded Funds

August 22nd

Exchange-traded funds (ETFs) and other hot “alternative investments” such as exchange-traded notes and master limited partnerships specializing in commodities like oil, currencies and gold hold a lot of appeal with current investors. Statistics show that ETFs specializing in commodities, currencies and other alternative assets brought in $38 billion in new money from investors in 2009, $14 billion in 2010 and $7 billion in 2011 so far.

Given the 2008 plummet in the value of conventional stocks, it is easy to understand the appeal of such investments in alternatives such as commodities and currencies. However, ETFs can have a dark side. Despite their many potential investment-related benefits, ETFs have the potential to wreak havoc on your tax bill.

Tax Traps Unknown to Many Investors

Given that commodity investments such as ETFs have long been praised for their exceptional tax efficiency, these funds can hold a surprising number of potential tax traps. Among these are rising tax preparation bills, odd tax rates, and unanticipated filings and tax on some assets in tax-sheltered individual retirement accounts.

Many tax preparers are feeling concern over the number of investors who enter into ETFs without full knowledge of the potential effect on their tax returns. Investors often don’t realize that even though ETFs trade like stocks and provide diversification like a fund, they are actually structured very differently and are, therefore, taxed differently. Inaccurate tax filing can lead to problems with a tax return and tax debt.

For example, while holders of gold stocks in mutual funds would have to pay 15 percent tax on long-term capital gains, those who hold gold shares would pay 28 percent tax on gains because physical gold is considered a “collectible.”

Holders of exchange-traded funds must also often file tax returns in multiple states, which can substantially raise tax costs and the amount of time and effort it takes to process returns.